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Fallen Blue Chip Could Yield 20% a Year as It Stages Its Comeback

While the bull run in many of the leading blue-chip stocks is getting a bit long in the tooth, this one's rebound may just be getting started.

Fallen Blue Chip Could Yield 20% a Year as It Stages Its Comeback

Zachary Scheidt
June 14, 2014

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While the Dow Jones Industrial Average may be within striking distance of its all-time highs, the bull run for many of the leading blue-chip stocks is getting a bit long in the tooth. Valuations for a number of key components are high compared with historical norms, leaving them vulnerable to a pullback.

The rally may very well continue for weeks (if not months), but at this point, the reward-to-risk ratio for buying many of these inflated stocks is not very good. Furthermore, I'm hesitant to set up even short-term income plays on some of these well-loved stocks, because while we may lock in a small gain on our trade, the risk of loss when sentiment shifts makes these opportunities much less attractive.

Instead of selling puts on a stock that has already experienced a significant run, I want to focus on a former blue chip that has faced significant challenges — Alcoa (NYSE: AA).

AA is certainly in a bullish trend, but shares are still more than 20% below their April 2011 highs, and nearly 70% below the 2007 highs.

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Alcoa is one of the largest producers of aluminum. Similar to our trade in iron ore producer Vale SA (NYSE: VALE) earlier this week, it has had to deal with lower pricing and concerns about the Chinese economy. With expectations for infrastructure growth in China waning, aluminum prices have been falling for the past three years.

At this point, there are some very solid arguments that can be made for a rebound in aluminum prices. First, the U.S. economy is steadily improving and recent auto sales figures show signs of increasing demand. Second, aluminum appears to have found support above the $1,700 per ton level, with spot prices briefly topping $1,800 per ton in the second quarter of 2014.

Finally, the slowdown in China has been widely discussed among investment professionals and the financial media. At this point, the concerns appear to be fully priced in. Any improvement in the prognosis for China's infrastructure spending, along with rising auto sales or other data points that suggest increased demand for aluminum, would likely have a bullish effect on aluminum prices, and in turn, on Alcoa's stock.

It is interesting to note that Alcoa has been trending higher over the past few months even while aluminum prices have been struggling to find support. This bullish price action could indicate significant underlying support for AA as investors place their bets on a continued global economic recovery.

From a valuation perspective, AA is not cheap. The company is expected to earn $0.46 per share this year, so at its current price, investors are paying roughly 30 times earnings. However, analysts expect earnings of $0.67 next year. This represents year-over-year growth of 46% and gives the stock a forward P/E multiple of 22.

To set up our income trade, I want to sell the AA Jul 14 Puts, which are trading near $0.30. I recommend traders enter a limit order at $0.25 to ensure an attractive level of income. For each contract we sell, we generate $25 in premium and are obligated to purchase 100 shares of AA at the $14 strike price should the stock close below this level when the puts expire on July 18.

With the premium collected, our net cost would be lowered to $13.75 per share. My expectation is that AA will remain above $14 and the puts will expire worthless, but we need to set aside $1,375 per contract (along with the $25 in premium) in case we are assigned shares.

Assuming the puts expire and we get to keep the $25 free and clear, we will realize a return of 1.8% over the $1,375 in capital set aside in the next 33 days. This nets out to a per-year rate of return of 20%.

If AA pulls back a bit and we are required to buy shares, I would be happy to own them at a net cost of $13.75. Given the strength of the stock in the face of challenging aluminum pricing and the possibility for a bullish sentiment shift regarding China's infrastructure plans, AA looks like a great investment right now, and an even better income opportunity.

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